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A tip from a superinvestor to every aspiring superinvestor

Sep 26, 2015

In this issue:
» Another lost decade around the corner?
» SEBI action against money laundering via stock splits
» Global market updates
» ....and more!

00:00
There are days you get insights and there are days when you get some super insights from people you admire the most. It gets even special when the insight comes from a gentleman of the Warren Buffett breed who are willing to share every pearl of wisdom with lesser mortals.

Howard Marks' memos to investors in Oaktree Capital are always a delight to read. The latest one, however, challenges every aspiring superinvestor to raise the bar in 'thinking'.

Now, do you remember your goal in investing? It is not to earn average returns. It is to do much better than the average investor. And for that your thinking has to be better than them. Your fellow investors may be smart, well informed and having the aid of computerized information feed. So to have an edge over them you must have an insight they don't possess. You have to react differently to complex situations and behave differently in times of euphoria and panic. In short, being right may be a necessary condition for investment success. But that won't be sufficient.

You must be more right...more often than others. Which means by definition your thinking must be different.

As Marks had put in his 2007 memo - Everyone Knows -first level thinkers like things with obvious appeal. But unusual risk adjusted returns are not fetched with such buys.

Consider some of these examples...

First level thinking: It's a good and well known company...lets buy the stock.

Second level thinking: It's a good company...but everyone thinks its a great company. The growth prospects and sustainable profits are overrated and over- priced. Time to sell.

First level thinking: There is risk of lower growth and poor profits in the stock...lets sell.

Second level thinking: The growth and profit concerns are temporary but everyone is selling in panic! The upside far exceeds the downside risks...time to buy the stock.

First level thinking: Product failure, litigations, regulatory hurdle and rising costs. No near term visibility...so sell the stock.

Second level thinking: The company has a solid moat and a track record of overcoming crisis for decades. Time to buy....(think Tata Motors, Nestle, Volkswagen)

Therefore the first level of thinking is so simplistic that almost everyone can attempt it. The second level needs better understanding of the company, its business, past history and its intrinsic value. It is as forward looking as backward.

The problem with first level thinkers is that they fail to distinguish between fundamental and investment risk. And they fail to appreciate the defining role of price.

So to turn yourself into a second level thinker (and a superinvestor) there are two principles that you need to keep close to your heart.

  • There is no asset so good that it can't become overpriced and therefore very risky.
  • There are very few assets so bad that there's no price at which they are safe buys.

Have you come across situations where second level thinking on a stock have paid off? Let us know your comments or share your views in the Equitymaster Club.

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02:20
 Chart of the day
What country comes to your mind when you hear the phrase 'The Lost Decade'? Japan, isn't it? The phrase is commonly used to describe the economic stagnation the country faced after its enormous asset price deflation.

Do you know who's next in line to meet the same fate? Well, as per the popular short seller, Jim Chanos, it could be none other than Japan's arch rival China. For a country that has carried world economic growth on its shoulders for many years now, that's certainly as controversial a comment as they come. However, Chanos is not exactly known for shooting his mouth off for the sake of it. He has argued that the debt to GDP situation in China is starting to look eerily similar to where Japan was just before it hit the proverbial iceberg.

For example... Japan's debt to GDP had jumped up to 176% before things started to unravel. As today's chart of the day highlights, China is currently more than 200% and that's a definite warning signal if the previous crises are anything to go by. In fact, as per a lot of research papers, the number that should start making policymakers nervous is between 80-100%. The magnitude of overshooting of not just China but several other nations also is certainly worrisome.

Growth in Debt to GDP: China competing with Japan and Greece

03:30
There have been many instances in the past when events like stock split have driven stock price higher. On the other hand, the real purpose for such activity, which is to improve liquidity, hardly saw any change. While stock splits do nothing to add value for shareholders, investors often fall for such gimmicks. There have been enough cases where stock splits were misused to push up stock price and to evade taxes. In fact, it has been at times reduced to a money laundering mechanism, especially in case of small value stocks.

As the market regulator seems set to tighten the noose over stock market's miscreants, the investors may see decline in events like stock split. As per an article in Business Standard, SEBI is planning to set a floor price of Rs 500 for stock split. While the intent is good, this is hardly a perfect solution we believe. With enough loop holes in the system, manipulators will find another way to launder money. On the other hand, the blanket rule may limit liquidity in good businesses, thus depriving retail investors of the opportunity to invest in them.

04:35
The week started with a sigh of relief as the US Federal Bank did not hike interest rates on 17th September. Markets surged upwards on Friday after Federal Reserve Chair Janet Yellen said that the US central bank was on track to raise interest rates this year. The US economy grew more than previously estimated in the second quarter on stronger consumer spending and construction. Gross domestic product rose at 3.9%, up from the 3.7% reported in August.

Among the major Asian stock markets, stocks in Japan and China were down by 3.4% & 0.2% respectively. The India indices closed the week down by 1.4% owing to the global cues. The net outflow from foreign institutional investors (FII) during the week was Rs 10.38 bn.

Performance during the week ended 25 September, 2015

04:45
 Weekend investing mantra
"One of the biggest mistakes is to focus on a stock price instead of its value."- Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst).

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